The most fundamental change affecting the value of investments in competitive electricity markets is the inherent uncertainty about electricity prices in electricity markets. The uncertain future level of prices from investment in generation creates a risk for the investor. While this risk affects all generating technologies, it does so in different ways. Although all generation technologies within a given market are subject to largely the same time of day price of electricity, the level of exposure to this price risk varies considerably between generating technologies. As a result, electricity price risk turns out to be an important risk factor affecting technology choice in investment appraisal.
Technologies which have a higher specific investment for capacity even though they may have relatively low fuel costs - for example wind or nuclear - are more greatly affected by this risk because there is less they can do to respond. Thus, although high capital cost and low fuel cost technologies will likely be competitive in the short-run and therefore produce electricity, they will be more exposed to cover capital employed. A company that is reliant on such technologies may find itself in financial difficulties if prices slump for a prolonged period of time.
Estimating the profitability of an investment must rely on modelling, requiring knowledge of the future costs and the future revenues of the generating project and their variation. For a company which has a choice of generating options, with different lead times and different uncertainties in costs, a uniform methodology must be developed to compare technologies with different characteristics. In this article we will briefly look into the cost considerations of energy technology under liberalised energy markets.
The Levelised (technology) cost of energy methodology, a widely accepted costing method for investments, has been a useful tool for investors and for overall economic analysis because it evaluated costs and energy production, and discounted them to take account of the time value of money. It provided an objective basis on which to provide a comparison of different technologies for baseload power generation. Estimates of technology cost have also played a substantial role in the formulation of policy instruments. Government estimates of levelised costs appear to have played a key role in decision making. Unit cost estimates are so prevalent in policy analysis in the hands of policy makers that we need to look closely at how these estimates relate to investment decisions.
The Levelised cost of energy can be thought of as "the price at which energy must be sold to break even over the lifetime of the technology". It yields a net present value in terms of pence/kWh. This is an assessment of the economic lifetime energy cost and lifetime energy production, and can be applied to essentially any energy technology. For computing the financial costs the equations can be embellished to take into account not only system costs, but also factors such as financing, insurance, maintenance, and different types of depreciation schedules.
This approach reflects the reality of long-term financing, passing on costs to the customers, known technology paradigms, a predictable place in the merit order, a strong increase in consumption and a short build-up time for selling the output of a new plant. Levelised costs were used to provide an approximate estimate of the relative merit of different technologies. Cost-minimisation was a key driver, so levelised costs were often the starting point for the analysis of technology choice. Many other factors could then be incorporated into the system design for achieving cost-minimisation.
The levelised cost approach involves:
Given the long-term nature of electricity investments, investment decisions in baseload generating capacity are being made on the basis of long-term fundamentals rather than looking at short-term behaviour in the spot or forward electricity markets. The Discounted cash flow (DCF) approach remains useful for providing a comparison among power generation technologies. Power companies will apply the DCF methodology based on an internal target for return on equity (the "hurdle rate") to make a decision on whether to invest or not and to decide between different projects. To assess various risks, different scenarios or sensitivities will be calculated, which often give a good assessment of the risks involved. This approach - that can improve a discounted cash flow analysis - is to discount costs and revenues at different rates according to their riskiness. Thus, for a power plant with more or less fixed costs but very uncertain revenues - the costs can be discounted at a low rate but revenues at a very high rate reflecting the uncertainty in future prices - the result can be an even higher effective discount rate. If a major cost component (such as fuel cost) is highly uncertain, then its costs should be discounted at an even lower rate, meaning the present value of costs is increased because of uncertainty.
Cost estimates have limitations, in part because there is a range of plausible estimates for any given technology and market assumptions. Cost estimates also cannot capture the other factors in competitive electricity markets including price, revenue and rates of return. Hence cost estimates alone are not a reliable guide to how investors will act in liberalised electricity markets.
The investors in electricity markets are concerned about the profitability of their investments against the risk to the capital employed. The investors will choose a generating technology that incorporates risks and is also the most economic choice available. Unfortunately, it is difficult for the technology cost (levelised) methodology to incorporate risks effectively. Thus it needs to be complemented by approaches that account for risks in future costs and revenues. The level of risk anticipated by an investor in a power plant will be reflected in the level of return expected on that investment. The greater the business and financial risks, the higher the return that will be demanded.
Returns depend on revenues as well as cost, so the price of electricity becomes an important risk factor in the investment decision. The origins of price risks are in competitive markets. If electricity prices were fixed or stable then it would be possible to capture many of the issues by using levelised costs. The level of financial risk in competitive markets is higher when compared to pre-liberalised conditions, but in theory it ought to be possible to capture the implications of this through adjustments to the finance assumptions used to generate levelised costs. Indeed, recent analyses of levelised costs undertaken to inform policy has generally used "private sector" discount rates.
This article has introduced the sources of risk, focussing in particular on electricity price risk, and how this can affect financial appraisal of power generation investments. Taking risk factors into account investors can make more adjusted decisions, as risk can affect both the financing of projects and the cost of capital. Investments with lower risk should have correspondingly lower "hurdle rates" for investment.
I hope you found this article interesting. I think it will take a few more articles to discuss this whole subject, as there is a large area to cover. I will attempt to analyse revenue risk in the next article. I will also analyse the removal of long term price risk while looking into the elements of EMR, as covered in The National Grid's EMR work:
Please follow this post over the next several weeks, and if you want to send me feedback then I look forward to hearing from you.
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